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Should You Use Market Neutral Strategies?

Should You Use Market Neutral Strategies?
By Ron DeLegge, Editor
April 1, 2011

SAN DIEGO ( Ė After peaking at a closing level of 14,164 on October 9, 2007, the Dow Jones Industrial Average (NYSEArca: DIA) did something few people expected. Less than 18 months after celebrating all-time highs, it experienced a 54.5% drop in value to 6,440 in March 2009. But thatís not all.

By averaging the October 2007 high with the March 2009 low we arrive at a mid-point for the Dow of 10,302, which is 19% above todayís levels. And while this sheds perspective on the half-way mark between a recent set of peaks and valleys in stocks, it raises another compelling question: Are we half way up or are we half way down?

A market neutral strategy attempts to eliminate some of the guessing. Instead of having a bullish or bearish bias it simply aims to reduce or hedge market risk/volatility by owning an asset or combination of assets not correlated to a particular market.

During a sharp up-trending market, a market neutral strategy is likely to underperform. Conversely, during a sharp down-trending market, a market neutral strategy is likely to outperform. And during a direction-less market, the strategy can also deliver. Ideally, the market neutral investment strategy will exhibit low correlation to market conditions.

Letís analyze a few market neutral strategies.

Market Neutral Funds
The hedge fund space is littered with products that propose to offer market neutral strategies. The Market Neutral Equity Index contains 229 active hedge funds that use this strategy. In 2010 this index produced a 4.01% gain, which was less than the broader U.S. equity market (NYSEArca: VTI). Most individuals, minus high net worth and institutional investors, are excluded from investing in hedge funds. And given that most hedge funds fail to live up to their expectations, itís probably not a bad thing.

For the investing masses mutual funds with no net worth minimums catering to market neutral strategies have been introduced.

One example is the Highbridge Statistical Market Neutral Fund (HSKAX), a $2.35 billion fund thatís part of JP Morganís managed investments lineup. HSKAX invests in securities it believes are undervalued and sells short securities it thinks are overvalued. It takes long and short positions selected from a universe of mid- to large sized stocks with characteristics similar to those of the Russell 1000 Index (NYSEArca: IWB). Even though it scored a return of 9.79% in 2008, its 3-year load adjusted returns (through August) are a disappointing minus 0.71%.  

A fundamental problem with market neutral funds isnít so much their investment strategy as it is their elevated ownership costs. According to Morningstar, the typical market neutral mutual fund has annual expenses of 2.06% and that doesnít even include other hidden costs like internal brokerage commissions or taxes.

Creating Your Own Market Neutral Strategy
Individual investors and financial professionals can create their own market neutral strategy using ETFs as the primary building blocks. ETFs have lower cost annual costs, they provide intraday liquidity and they offer the ability to hedge positions by using call and put options.

The ETF Profit Strategy Newsletter analyzed various market neutral ETF portfolios that hold both long and short positions. These particular combinations will give you a good start on how to create and execute your own market neutral strategy. 

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